• Covenant Not to Compete May Survive Rejection of Executory Contract
  • March 25, 2005 | Author: Maita Deal Prout
  • Law Firm: Holland & Knight LLP - Los Angeles Office
  • Covenants not to compete are common in franchise agreements, agreements involving the sale of businesses, employment agreements and other contracts. A typical covenant not to compete restricts the right of one of the parties to engage in business activities that compete with the other party for a specified period of time. For example, franchise agreements universally include a covenant that precludes the franchisee from competing with the franchisor during the term of the franchise relationship and for a period of time after termination of the franchise.

    The rejection of an executory contract by a debtor is a routine occurrence in a bankruptcy case.1 Section 365 of the Bankruptcy Code gives the debtor or bankruptcy trustee the right, with court approval, to assume or reject any executory contract of the debtor. A debtor may elect to reject a franchise agreement, an employment agreement or other executory contract that includes a covenant whereby the debtor has agreed not to compete with the non-debtor party. In the face of the right to reject an executory contract in bankruptcy, the question arises as to the continued effectiveness of an otherwise enforceable covenant not to compete when the debtor rejects the contract in which the covenant is contained.

    As a general principle, an executory contract must be assumed or rejected in its entirety, or not at all. See In re Rovine, 6 B.R. 661, 666 (Bankr. W.D. Tenn. 1980). The Bankruptcy Code does not provide for "selective assumption or rejection." In re Steaks To Go, Inc., 226 B.R. 35, 38 (Bankr. E.D. Mo. 1998). Consequently, non-debtor parties to executory contracts will often argue that a covenant not to compete is a separate agreement, supported by separate consideration, that should survive the rejection of the contract. See, e.g., In re Silk Plants, Etc. Franchise Systems, Inc., 100 B.R. 360, 362 (M.D. Tenn. 1989); In re Annabel, 263 B.R. 19, 23 (Bankr. N.D. N.Y. 2001); In re Noco Inc., 76 B.R. 839, 840-41 (Bankr. N.D. Fla. 1987). Typically, however, the parties to the executory contract do not intend that the covenant not to compete be a separate agreement, resulting in the rejection of the covenant. E.g., In re Silk Plants, Etc. Franchise Systems, Inc., 100 B.R. at 362. The rejection of an executory contract containing a covenant not to compete does not mean, however, that the covenant is not enforceable against the debtor.

    Rejection of an executory contract constitutes a breach "immediately before the date of the filing of the petition." 11 U.S.C. ยง 365(g). In other words, the contract is treated as though it had been breached just before the bankruptcy was filed. In the view of most of the federal courts of appeal that have considered the issue, rejection is not equivalent to termination or repudiation of the contract. E.g., In re Columbia Gas System, Inc., 50 F.3d 233, 239 n.8 (3d Cir. 1995); In the Matter of Austin Dev. Co., 19 F.3d 1077, 1082 (5th Cir.), cert. denied sub nom., Sowashee Venture v. EB, Inc., 513 U.S. 874, 115 S.Ct 201 (1994) (mem.); In re Modern Textile Inc., 900 F.2d 1184, 1191 (8th Cir. 1990); Leasing Service Corp. v. First Tennessee Bank Nat'l Ass'n, 826 F.2d 434, 436-37 (6th Cir. 1987). Consistent with this view, the contract continues to exist after rejection, and the rights and duties of the parties are essentially the same after rejection as they would have been if the contract had been breached pre-petition. In re Alongi, 272 B.R. 148, 154-55 (Bankr. D. Md. 2001). "[R]ejection operates as a breach of an existing and continuing legal obligation of the debtor, not as a discharge or extinction of the obligation itself." In re Steaks To Go, Inc., 226 B.R. at 38, quoting In re Modern Textile, Inc., 900 F.2d at 1192.

    A number of courts have considered the post-rejection enforceability of covenants not to compete. The outcome of many of those cases turns on an analysis of the available remedies for breach of the covenant not to compete under state law. In particular, the courts examine whether the right to enforce the covenant can be reduced to monetary damages. E.g. In re Hughes, 166 B.R. 103 (Bankr. S.D.Ohio 1994); In re Kilpatrick, 160 B.R. 560 (Bankr. E.D. Mich 1993). If the non-debtor's remedy can be reduced to money damages, the obligation of the debtor not to compete is a "debt" that is subject to discharge through the bankruptcy. Discharge of the obligation means that the covenant not to compete will not be enforceable. Thus, in In re Ward, 194 B.R. 703, 712 (Bankr. D. Mass. 1996), the court found that under state law the franchisor could elect to seek either an injunction or monetary damages for breach of the covenant not to compete. Because the non-debtor party had an adequate remedy at law, the bankruptcy court determined that the franchisor's claim was a dischargeable debt and held that the franchisor had no ongoing right to enforce the covenant. Id. at 714-15. Similarly in In re Silk Plants, Etc. Franchise Systems, Inc., the district court concluded that because nothing under Tennessee law prohibited the non-debtor from obtaining money damages, the decision of the bankruptcy court that the breach of the contract gave rise to a claim for damages should be upheld, resulting in the determination that the covenant not to compete was unenforceable. In re Silk Plants, Etc. Franchise Systems, Inc., 100 B.R. at 362-63.

    On the other hand, the non-debtor may not have an adequate remedy at law. Under such circumstances, the debtor's rejection of the contract does not disturb the non-debtor party's right to enforce the covenant not to compete through an injunction. For example, in In re Printronics, Inc., 189 B.R. 995 (Bankr. N.D.Fla. 1995) the court found the exclusive remedy under state law for the debtor's post-rejection breach of a covenant not to compete to be an injunction. Therefore, the court held that the debtor/franchisee's covenant not to compete was enforceable notwithstanding rejection of the franchise agreement. In re Printronics, 189 B.R. at 1003-04. Similarly, in In re Udell, 18 F.3d 403 (7th Cir. 1994), the court determined that the non-debtor's right to an injunction under state law existed independently from any damage claim, and, therefore, was not a claim dischargeable in bankruptcy. Consequently, the covenant not to compete was enforceable. In re Udell, 18 F.3d at 408; e.g., In re Kennedy, 267 F.3d 493, 497-98 (6th Cir. 2001) (under Iowa law, equitable relief is not an alternative to right to payment for future injuries and, accordingly, injunction issued to enforce covenant not to compete contained in the rejected contract will not be discharged).

    Some courts have used other reasoning to uphold the post-rejection enforceability of covenants not to compete. In In re Hughes, 166 B.R. 103 (Bankr. S.D. Ohio 1994), the bankruptcy court determined that if the debtor was required to spend money to comply with the covenant, then a claim results which is subject to discharge, but if no expenditure of money would be required, the covenant is enforceable. In re Hughes, 166 B.R. at 106 (citation omitted). Because the debtor could comply with the covenant without expending funds, the non-debtor was afforded relief from the automatic stay in order to pursue an injunction to enforce the covenant not to compete. Id. The covenant not to compete in In re Steaks To Go, Inc., 226 B.R. 35 (Bankr. E.D. Mo. 1998) was in a rejected franchise agreement. The bankruptcy court determined that the covenant not to complete was enforceable on the basis that rejection of the franchise agreement resulted in a breach, not a termination, of the franchise agreement. In re Steaks To Go, Inc., 226 B.R. at 38. In In re Hirschhorn, 156 B.R. 379 (Bankr. E.D. N.Y. 1993), the bankruptcy court determined that there were no remaining obligations of the parties under the sublease other than the debtor's compliance with the covenant not to compete. In re Hirschhorn, 156 B.R. at 389. Accordingly, the court determined that there was no executory contract that could be rejected and, consequently, the covenant remained enforceable. Id. and cases cited therein.

    When an executory contract containing a covenant not to compete is rejected, it is likely the debtor will take the position that the covenant not to compete is no longer enforceable. However, this is not necessarily the case. Depending on the specific facts of the case and the rights accorded the non-debtor party to the contract under applicable state law, the non-debtor may be able to enforce the covenant not to compete notwithstanding rejection of the contract.

    1 An executory contract is a contract under which the "obligations of both the bankrupt and the other party to the contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other." Countryman, Executory Contracts in Bankruptcy, Part 1, 57 Minn. L. Rev. 439, 460 (1973). Accordingly, if only one side of the contract has not been completed, the contract is not executory and cannot be rejected.